Successful efforts vs full cost

What is the successful efforts method?

Costs are capitalised only if they result directly in finding proved reserves. Geological and geophysical costs, such as seismic surveys, are expensed as incurred. The cost of an exploratory well is capitalised while the company determines whether it has found proved reserves, and expensed if it has not. Costs are accumulated by field or property, depleted over that field's reserves and tested for impairment field by field. Most large integrated oil companies use successful efforts.

What is the full cost method?

All costs of finding and developing reserves, including dry holes and geological and geophysical work, are capitalised in a cost centre, which under US rules is a whole country. The pool is depleted over all the reserves in that country on a units of production basis. Sales of properties usually reduce the pool with no gain or loss unless the sale would significantly change the depletion rate. The capitalised costs are capped by a ceiling test.

Successful efforts vs full cost: a four-well programme

A company spends CU 10 million on seismic surveys and drills 4 exploration wells at 25 million each. One finds a field with 20 million barrels of proved reserves; three are dry. In year 2 the field produces 2 million barrels, 10% of its reserves.

Over the field's life both methods expense the same CU 110 million. Successful efforts recognises the cost of failure at once and leaves a smaller asset; full cost spreads it over production, giving smoother profit and a larger balance sheet, until a fall in prices triggers a ceiling test write-down.

What is the full cost ceiling test?

Under SEC rules, a full cost company compares, each quarter, its capitalised costs, net of depletion and related deferred taxes, with a ceiling: broadly, the present value at 10% of future net revenues from proved reserves, using the average of first-day-of-the-month prices over the previous twelve months, plus the cost of unproved properties not being depleted, after tax effects. Any excess is written off and cannot be reversed. In sharp oil price falls, full cost companies have recorded some of the industry's largest write-downs for this reason.

Which method is allowed under IFRS?

IFRS 6 lets a company choose how much exploration and evaluation spending to capitalise, so both a successful efforts style policy and capitalising all costs for an area while it is being evaluated are allowed. But once technical feasibility and commercial viability are demonstrated, development assets fall under IAS 16 and IAS 36: they are depleted field by field and tested for impairment in cash-generating units no larger than the field or group of linked fields. Costs of unsuccessful areas cannot be carried in a country-wide pool and depleted against other fields' reserves, so a pure full cost method is not available under IFRS. See IFRS 6 exploration and evaluation.

What happens when a full cost company adopts IFRS?

IFRS 1 gives it an exemption: it can measure exploration and evaluation assets at the amount under its previous full cost accounting, and allocate the development and production pool to the underlying fields pro rata to their reserve volumes or values. The allocated amounts are tested for impairment at the date of transition. From then on, IFRS rules apply field by field.

How does impairment differ between the methods?

Under US GAAP, successful efforts companies apply the general impairment model to proved properties: an undiscounted cash flow recoverability test, then a write-down to fair value, with no reversal. Full cost companies apply the ceiling test instead. Under IFRS, all companies apply IAS 36, which compares carrying amount with recoverable amount directly and requires reversals if conditions improve. See impairment of oil and gas assets.

Why does the choice matter to investors?

Profit, assets, return on capital and depletion per barrel all differ between the methods, even with identical operations. Analysts often compare cash flow measures, such as operating cash flow before exploration spending, to neutralise the choice. See depletion and units of production and oil and gas accounting.

This guide is general information. It is not tax or legal advice for your situation.